Externalities

1. Externalities I NyomanSudapet,SE Pertemuan 10

2. Market Efficiency - Market Failures Recall that: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen.

3. Market Failures: Externalities • When a market outcome affects parties other than the buyers and sellers in the market, side-effects are created called externalities. • Externalitiescause markets to be inefficient, and thus fail to maximize total surplus.

4. An externality arises... . . . when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

5. Market Failures: Externalities • When the impact on the bystander is adverse, the externality is called a negative externality. • When the impact on the bystander is beneficial, the externality is called a positive externality.

6. Examples of Negative Externalities • Automobile exhaust • Cigarette smoking • Barking dogs (loud pets) • Loud stereos in an apartment building

7. Examples of Positive Externalities • Immunizations • Restored historic buildings • Research into new technologies

8. Price of Aluminum Equilibrium QMARKET The Market for Aluminum... Supply (private cost) Demand (private value) 0 Quantity of Aluminum

9. The Market for Aluminum and Welfare Economics The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

10. The Market for Aluminum and Welfare Economics If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

11. The Market for Aluminum and Welfare Economics For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

12. Social cost Cost of pollution Price of Aluminum Optimum Equilibrium QMARKET Qoptimum Pollution and the Social Optimum... Supply (private cost) Demand (private value) 0 Quantity of Aluminum

13. Negative Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.

14. Achieving the Socially Optimal Output Internalizing an externality involves altering incentives so that people take into account the external effects of their actions.

15. Achieving the Socially Optimal Output The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

16. Positive Externalities in Production When an externality benefits the bystanders, a positive externality exists. The social costs of production are less than the private cost to producers and consumers.

17. Positive Externalities in Production A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

18. Price of Robot Value of technology Social cost spillover Equilibrium Optimum QMARKET QOPTIMUM Positive Externalities in Production... Supply (private cost) Demand (private value) 0 Quantity of Robots

19. Positive Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. • The optimal output level is more than the equilibrium quantity. • The market produces asmaller quantity than is socially desirable. • The social costs of production are less than the private cost to producers and consumers.

20. Internalizing Externalities: Subsidies Government many times uses subsidies as the primary method for attempting to internalize positive externalities.

21. Technology Policy Government intervention in the economy that aims to promote technology-enhancing industries is called technology policy.

22. Technology Policy • Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. • The patent is then said to internalize the externality.

23. Internalizing Production Externalities • Taxes are the primary tools used to internalize negative externalities. • Subsidies are the primary tools used to internalize positive externalities.

24. Consumption Externalities... (a) Negative Consumption Externality (b) Positive Consumption Externality Price of Alcohol Price of Supply Education (private cost) Supply (private cost) Social Demand (private value) value Demand (private value) Social value 0 Q Q 0 Q Q Quantity of Quantity OPTIMUM MARKET MARKET OPTIMUM Education of Alcohol

25. Externalities and Market Inefficiency • Negative externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. • Positive externalities in production or consumption lead markets to produce a larger quantity than is socially desirable.

26. Private Solutions to Externalities Government action is not always needed to solve the problem of externalities.

27. Types of Private Solutions to Externalities • Moral codes and social sanctions • Charitable organizations • Integrating different types of businesses • Contracting between parties

28. The Coase Theorem The Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own and allocate resources efficiently.

29. Transactions Costs Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

30. Why Private Solutions Do Not Always Work Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

31. Public Policy Toward Externalities When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . command-and-control policies. market-based policies.

32. Command-and-Control Policies • Usually take the form of regulations: • Forbid certain behaviors. • Require certain behaviors. • Examples: • Requirements that all students be immunized. • Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

33. Market-Based Policies • Government uses taxes and subsidies to align private incentives with social efficiency. • Pigovian taxes are taxes enacted to correct the effects of a negative externality.

34. Examples of Regulation versus Pigovian tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could… tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

35. Market-Based Policies • Tradable pollution permitsallow thevoluntary transfer of the right to pollute from one firm to another. • A market for these permits will eventually develop. • A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

36. The Equivalence of Pigovian Taxes and Pollution Permits... (a) Pigovian Tax (b) Pollution Permits Price of Supply of Price of Pollution Pollution pollution permits P P Pigovian tax 1. A Pigovian tax sets the price of pollution... Demand for Demand for pollution rights pollution rights 0 Q Quantity of 0 Q Quantity of Pollution Pollution 2. ...which, together with the demand curve, determines the quantity of pollution. 2. ...which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution...

37. Summary • When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. • Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. • Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity.

38. Summary • Those affected by externalities can sometimes solve the problem privately. • The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently.

39. Summary • When private parties cannot adequately deal with externalities, then the government steps in. • The government can either regulate behavior or internalize the externality by using Pigovian taxes.

40. Graphical Review

41. Price of Aluminum Supply (private cost) Equilibrium Demand (private value) 0 QMARKET Quantity of Aluminum The Market for Aluminum...

42. Social cost Cost of pollution Price of Aluminum Supply (private cost) Optimum Equilibrium Demand (private value) 0 QMARKET Quantity of Qoptimum Aluminum Pollution and the Social Optimum...

43. Price Supply (private cost) of Robot Value of technology Social cost spillover Equilibrium Optimum Demand (private value) 0 Quantity QMARKET QOPTIMUM of Robots Positive Externalities in Production...

44. (a) Negative Consumption Externality (b) Positive Consumption Externality Price of Alcohol Price of Supply Education (private cost) Supply (private cost) Social Demand (private value) value Demand (private value) Social value 0 Q Q 0 Q Q Quantity of Quantity OPTIMUM MARKET MARKET OPTIMUM Education of Alcohol Consumption Externalities...

45. (a) Pigovian Tax (b) Pollution Permits Price of Supply of Price of Pollution Pollution pollution permits P P Pigovian tax 1. A Pigovian tax sets the price of pollution... Demand for Demand for pollution rights pollution rights 0 Q Quantity of 0 Q Quantity of Pollution Pollution 2. ...which, together with the demand curve, determines the quantity of pollution. 2. ...which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution... The Equivalence of Pigovian Taxes and Pollution Permits...